Causes of the shadow economy in Central and Eastern Europe

Abstract

Due to its clandestine nature, quantifying the shadow economy is a challenging task. Concealing incomes leads to large negative externalities: market distortions and loss of tax revenues cause enormous damage worldwide. Countries in Central and Eastern Europe (CEE) are in a precarious situation: their transformation from planned to market economies took place only recently, thus their corporate sector and institutional background do not have such long histories and deep traditions as in some other parts of the world. In our paper, we reveal causes of the shadow economy in CEE in a panel econometric framework by using data of the International Monetary Fund and other global organisations. We apply static and dynamic panel linear models and pay special attention to factors such as socio-economic development, institutional background, income inequalities, and taxation. Our results prove that the CEE region differs from the rest of the world in many aspects of the shadow economy, and points out the persistence of the shadow economy, the short-term nature of the impact of inflation and the long-term effect of income inequalities in the shadow economy. We conclude with some policy recommendations to whiten the shadow economy in CEE.